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Robert Rapier

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Is A New Price War Looming For OPEC?

Last week OPEC, Russia and other oil-producing nations agreed to additional oil production cuts in an effort to support oil prices. Following the 177th Meeting of the OPEC Conference in Vienna, OPEC said it would increase its production cuts by another 500,000 barrels per day (BPD).

This brings the total production cuts from OPEC and its allies to 1.7 million BPD. This continues the strategy adopted in late 2016 of limiting production. That decision followed what was ultimately a disastrous decision at OPEC’s November 2014 meeting to declare a price war on U.S. shale producers.

At that 2014 meeting, the Saudis argued that it didn’t make sense for them to cut production. The highest-cost producers, they argued, should be the ones to cut. So they embarked upon a strategy of recapturing market share.

That was certainly a rational argument, but it failed to anticipate how things would actually play out. I believe the Saudis underestimated the steep drop in the price of oil, and they failed to foresee the resilience of U.S. shale oil production.

Some shale producers did go bankrupt, and shale production temporarily fell, but most producers slashed costs and then continued to increase production.

The fall in oil prices cost OPEC members dearly, and at their November 2016 meeting they shifted strategies. They decided to cut production in order to support prices — even though that helps U.S. shale producers. Related: The Strange Disconnect Between Energy Stocks And Oil Prices

OPEC ultimately finds itself in a no-win situation. Its current strategy of cutting production to prop up oil prices will strengthen U.S. shale oil producers. That will likely enable shale production to keep growing, which may force deeper production cuts (which was the case for OPEC this year).

Consider OPEC’s alternative. If it didn’t make the production cuts, oil prices would surely fall. Again, that might cause shale oil production to fall. It might put some shale oil producers out of business. But there’s a big risk that it would play out like it did in 2014.

Meanwhile, transportation systems continue to electrify. Oil demand will slow and eventually decline (although I believe that’s more than five years away). Thus, OPEC probably has a limited number of years in which it can successfully prop up oil prices. It can’t afford to collapse oil prices leading up to a peak oil demand scenario. Related: The Next Major Middle East Oil IPO

Thus, OPEC’s decision is really the most logical decision, and likely foreshadows its strategy for years. The best-case scenario for OPEC is that U.S. shale oil production peaks and begins to decline in a few short years, and then the cartel can begin to regain market share at an elevated oil price.

It’s a gamble for OPEC, but it’s better than the alternative.

This strategy can also help support the market value of Saudi Aramco, which also went public last week at a valuation of $1.7 trillion. That was short of the $2 trillion value that had been suggested by Saudi Crown Prince Mohammed bin Salman, but better than the $1.5 trillion value I expected.

By Robert Rapier

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